Small-Cap ETFs: Look Beyond the Russell 2000 | ETF Trends

Investors should consider small-cap exchange traded funds beyond ones that reflect the Russell 2000 Index as the popular benchmark’s shortcomings may cause it to underperform other indices.

The Russell 2000 Index has trailed the S&P SmallCap 600, MSCI USA Small Cap and CRSP U.S. Small Cap indices by over an annualized 1.4% from the end of June 2011 through January 2015, according to Morninstar analyst Alex Bryan.

The iShares Core S&P Small-Cap ETF (NYSEArca: IJR), which tracks the S&P SmallCap 600, has generated a 9.3% average annualized return over the past 10 years while Vanguard Small Cap ETF (NYSEArca: VB) returned 9.8%. In contrast, the iShares Russell 2000 ETF (NYSEArca: IWM) gained 8.5%. [Small-Cap ETFs: Slight Differences are Important]

Bryan argues that the Russell 2000 incurs implicit transactions that could undermine performance. Specifically, as the index rebalances its holdings all at once, the concentrated trades could impact the price of the underlying holdings, which cause a drag on overall performance.

“The Russell 2000 Index is one of the most widely followed U.S. small-cap indexes and reconstitutes itself on a single day each year,” Bryan said. “The resulting trading volume in the stocks that the index’s reconstitution affects could cause it to suffer from greater market-impact costs than its peers.”

Most investors have come to expect the Russell 2000 to effect changes at the end of May. The index provider would rebalance both its Russell 1000 and Russell 2000 in response to new market-capitalization weights. Consequently, investors can anticipate the actions of the Russell 2000 indexer to bid up prices on new additions and bid down deletions between the end of May and the effective changes in June.